Pointers to help investors select an income fund manager

Investors who opt to invest in income funds are obviously keen to maximise their income. But if they are invested with a longer time horizon, they should look at several metrics when choosing a fund manager.

In a rising interest rate environment, there are certain challenges facing income fund managers. As Mike Ronald (pictured right), CFO Investment Professional with Marriott puts it, “There is a tension between the logic of being at the short end of the yield curve and the sentiment of being at the long end. This poses a challenge to the income fund manager in making investment decisions in the best interests of investors.”

A key metric is the fund’s weighted average term to maturity, which is the weighted average of the remaining life of all the financial instruments in the portfolio. Yield curves typically slope upwards which means that the longer the term, the greater the yield and vice versa. By investing at the longer end of the curve – in other words having longer dated instruments in the portfolio – a manager will be able to produce better returns.

However, when interest rates are rising, it benefits the fund to keep the term to maturity short. In this way, the instruments will mature early and the money can be reinvested at increasingly higher interest rates.

So, if the portfolio’s duration is long, this will initially reflect a higher return, but it will suffer from the opportunity cost of not being able to reinvest at higher rates as interest rates rise. Prospective investors should therefore consider both aspects of a fund, before making an investment decision.

Another thing which investors need to be aware of is what lies behind the yield that is quoted for a fund. Money market funds quote an annualised yield showing the yield that an investor would earn if money was kept and interest re-invested in the fund over a year resulting in a yield higher than a simple rate Some income funds may not annualise their rates and hence comparison might be difficult. It is best is to ask the investment manager how the quoted yields are calculated. Most communication centres are well briefed on this.

Although investors may wonder whether South African interest rates are set to continue rising, after the Reserve Bank left rates unchanged in January, many economists predict that more belt-tightening is on the way. Inflation accelerated to 8.6% in December 2007 and the outlook is poor with soaring food and fuel prices. SARB Governor Tito Mboweni noted that “The MPC remains committed to bringing inflation back to within the target range (3%-6%).”

For the first half of 2008 at least, the risk remains of further interest rate hikes.